In addition to being a human tragedy, the COVID-19 pandemic has accelerated existing structural trends and created new disruptions to the way we live and the world we live in. These macro changes are producing winners and losers, creating potential value for active investors as the dispersion of returns between sectors, credit qualities, and regions increases. Here are five credit ideas and charts that help illustrate the opportunity:
1. The search for yield
The monetary policy response to the pandemic has been unprecedented in size and scale. Rate cuts intended to stimulate the economy have brought global yields lower and, as of the end of November 2020, over 25% of global fixed income assets were negative-yielding. This means that investors looking for positive yield may have to increasingly move down the risk spectrum and towards credit for their income needs. Indeed, there have been significant inflows into credit mutual funds so far this year.
Chart 1: The search for yield may drive demand for credit assets
China was the first country affected by the COVID-19 pandemic, and also the first to recover: PIMCO forecasts that by the end of 2021, Chinese Gross Domestic Product (GDP) will be almost 15% above its 2019 level. This contrasts with U.S. GDP, which is likely to have only just reached its pre-pandemic levels. At the same time, and given prospects of a weaker U.S. dollar in 2021 and a “lower-for-longer“ interest rate environment, we expect inflows into emerging market (EM) Asia credit to continue. Finally, valuations for Asia credit may be attractive: The spread premium relative to U.S. credit is currently near three-year wides, as seen in the chart.
Chart 2: Credit spread premium for Asia credit vs. U.S. credit
The pandemic has affected different sectors unevenly. Technology, for instance, has rallied as our ways of working and consuming have become more digital, while sectors like hospitality and travel have been severely hit due to lockdown measures. Significant fiscal and monetary intervention has helped tighten credit spreads from the extreme levels seen in March 2020, but some sectors, especially those worst hit by the recession, are still far from their pre-pandemic levels. With vaccines in deployment and the economic recovery expected to continue, spreads in these hardest-hit sectors may be poised to outperform and offer further upside, particularly among more resilient issuers that have ample liquidity.
Chart 3: COVID-affected sectors have generally underperformed more defensive sectors in 2020
This year’s economic contraction increased the number of downgrades from investment grade (IG) ratings to high yield (HY) (known as fallen angels) to levels last seen in 2015–2016 after the plunge in global oil prices. This also meant that there was far more debt in the lowest IG bracket (BBB and BBB−) on downgrade watch by a rating agency than there was HY debt in the highest HY bracket (BB and BB+) being considered for an upgrade. The situation, however, has reversed now: For the first time in 13 years, and on the expectations of an economic recovery, over the near term there is more HY debt that could be upgraded (known as rising stars) than IG debt that could be downgraded, as seen in the chart.
Chart 4: More upgrades than downgrades?
U.S. high yield defaults spiked in April and May 2020, when an earnings slowdown resulting from global lockdown measures and collapsing oil prices hit weaker issuers within the asset class. Defaults, however, have gradually declined since then. As the economic recovery continues, defaults are likely to continue to decline, although they may remain elevated vs. long-term averages into 2021, highlighting the importance of active management and security selection.
Chart 5: Defaults: good news in the bad news
Source: BAML as of 30 Nov 2020. Chart shows quarterly defaulted debt in the ICE BAML US HY Index. Volume figure includes distressed exchanges.